Chapter 6 – Deductions and Losses (Principles of Federal Income Tax)

Vocabulary flashcards covering key terms and rules from Chapter 6 on federal income tax deductions and losses.

Adjusted Gross Income (AGI)

The income benchmark on Form 1040 that separates deductions taken "FOR" AGI from those taken "FROM" AGI; often called “the line.”

Deductions "FOR" AGI

Expenses subtracted before AGI, including trade or business expenses, rental/royalty expenses, student-loan interest, one-half of self-employment tax, and the QBI deduction.

Deductions "FROM" AGI

Itemized deductions subtracted after AGI, such as medical expenses, casualty losses, and charitable contributions, many of which are subject to thresholds or limits.

§162 Trade or Business Expenses

Ordinary and necessary costs incurred in carrying on a trade or business that are generally deductible FOR AGI.

§212 Production-of-Income Expenses

Ordinary and necessary costs incurred by individuals for the production or collection of income; deductible only when specifically allowed.

Ordinary Expense

A normal, common, and accepted cost for a particular business or investment activity.

Necessary Expense

A cost that is appropriate and helpful to the taxpayer’s business or income-producing activity.

Reasonable Expense

An expenditure whose amount is not excessive in relation to its purpose.

Schedule 1 (Form 1040)

The schedule where most FOR-AGI deductions are first listed before being carried to page 1 of Form 1040.

Trade or Business Classification

An activity in which the taxpayer holds themself out to others as selling goods or services, giving greater flexibility for deducting expenses and losses.

Investment Classification

Property or activities held for investment; losses are usually capital and deductions are typically FROM AGI and subject to more limits.

§179 Deduction

Election allowing immediate FOR-AGI deduction of up to $1,220,000 of newly acquired trade or business tangible property (2024 amount).

Capitalization (§263)

Requirement to add certain expenditures to the basis of property when they create a permanent improvement, betterment, or restoration.

Election to Capitalize (§266)

Optional capitalization of normally deductible carrying charges, such as taxes or interest on unimproved real estate, at the taxpayer’s choice.

Expenses Related to Exempt Income (§265)

Costs, such as interest incurred to purchase tax-exempt bonds, that are nondeductible to prevent a double tax benefit.

Expenses Contrary to Public Policy

Payments that are illegal or penalize illegal acts—e.g., fines, bribes, kickbacks—are nondeductible.

Kickback

An illegal payment to induce business; specifically nondeductible under public-policy rules.

Rebate

A reduction in the purchase price paid directly to the purchaser; treated as an income reduction rather than a deduction for the payor.

Business Interest Expense Limitation (§163(j))

Deduction generally limited to business interest income plus 30% of adjusted taxable income, unless average gross receipts are below $30 million.

Start-Up Costs (§195)

Pre-opening business expenditures; up to $5,000 (phased out over $50,000) may be deducted currently, with any excess amortized over 180 months.

Legal and Accounting Fees

Deductible FOR AGI when incurred in a trade or business (e.g., preparing Schedules C, E, F); personal legal fees are not deductible.

Cash Method – Prepaid Expenses

Generally nondeductible when paid, except prepaid rent covering ≤ 1 year and required by lease may be deducted immediately.

Cash Method – Prepaid Interest

Interest must be deducted over the period to which it relates; points on a principal residence may be deducted immediately if four specific tests are met.

Points (Loan Origination Fees)

Prepaid interest expressed as a percentage of the loan; deductible in the year paid on a purchase of a principal residence when statutory tests are satisfied.

Accrual Method – All-Events Test

Deduction allowed when liability exists and the amount can be determined with reasonable accuracy.

Economic Performance Test

For accrual taxpayers, deduction is allowed only when the underlying economic activity giving rise to the liability has occurred.

Recurring-Item Exception

Allows accrual taxpayers to deduct certain recurring expenses if economic performance occurs within 8½ months after year-end and proper matching is achieved.

Wash Sale Rule

Disallows a loss on stock or securities if substantially identical property is bought within 30 days before or after the sale (61-day window).

Related-Party Loss Disallowance (§267)

Prohibits deduction of losses on sales between related parties; the buyer may later offset the disallowed loss against gain on resale.

Related Party – Family Members

Includes spouse, ancestors, lineal descendants, brothers, sisters, and half-siblings for purposes of §267 loss disallowance.

Attribution Rules

Ownership of stock may be deemed through family, partnerships, corporations, or trusts when applying related-party provisions.

Hobby Loss Rules

If activity does not show a profit in at least 3 of 5 consecutive years, deductions are limited to hobby income; burden shifts to IRS if the 3-of-5 test is met.

Vacation Home "Residence" Test

Property is a residence if personal use exceeds the greater of 14 days or 10% of rental days, triggering §280A limitations.

Primarily Personal (Category 1)

Vacation home rented < 15 days; rental income is excluded, and only Tier 1 (e.g., mortgage interest, taxes) personal deductions are allowed.

Mixed Personal and Rental (Category 2)

Home rented > 15 days with personal use exceeding the 14-day/10% threshold; rental deductions are limited to rental income after allocation.

Primarily Rental (Category 3)

Home rented > 15 days and personal use does not exceed the threshold; all allocated rental expenses are deductible, subject to passive-loss rules.

Rental Expense Allocation Formula

Rental Use Expense = Total Annual Expense × (Rental Days ÷ Total Days Used).

Business Start-Up Current Deduction

Maximum $5,000 immediate deduction of start-up costs, reduced dollar-for-dollar once total start-up costs exceed $50,000.

§162(e) Lobbying Expenses

Lobbying costs to influence legislation are nondeductible, except for local matters directly affecting the business or when total is < $2,000.

Drug Trafficking Exception

Businesses engaged in illegal drug dealing may deduct only cost of goods sold; no other deductions are allowed under federal law.

Tax Planning – Timing of Deductions

Shifting deductions between years by controlling payment or economic performance can reduce current taxable income within statutory limits.

Tax Compliance – Substantiation

Adequate records and documentation are required to support deductions, especially for travel, entertainment, and mixed-use property.